Implications of Higher Real Rates on Valuations and Portfolio Construction

Lisa Shalett, Chief Investment Officer of Morgan Stanley Wealth Management, discusses long-term investors’ biggest concern – the amount and timing of interest rate moves.

Lisa Shalett is a member of Morgan Stanley’s Wealth Management Division and is not a member of Morgan Stanley’s Research Department. Unless otherwise indicated, her views are her own and may differ from the views of the Morgan Stanley Research Department and from the views of others within Morgan Stanley.

----- Transcription -----

Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley. 

Lisa Shalett: And I'm Lisa Shalett, Chief Investment Officer for Morgan Stanley Wealth Management. 

Andrew Sheets: And on this special episode of the podcast, we'll be discussing some of the latest market trends and what they may mean for our retail clients. It's Tuesday, January 23rd at 4 p.m. in London. 

Lisa Shalett: And it's 11 a.m. here in New York.

Andrew Sheets: Lisa, it's great to have you back on. So wealth management clients are typically investing for the long term in order to meet specific goals such as retirement. And with that in mind, let's start with the current market backdrop. You know, we've entered the year with increased market confidence. We've seen implied volatility near some of the lowest levels that we've seen in several years. And yet we've also seen some mixed economic data to start the year. So as you look out into 2024, what are the major risks that you're focused on?

Lisa Shalett: Well, I think one of the first things that, you know, we're trying to impress upon our clients, who tend to be long term, who tend to be multi-asset class investors, very often owning a simple classical 60/40 portfolio, is that we've been in this very interesting potential regime change, where both bonds and stocks are sensitive to the same thing. And that is the level and rate of change of interest rates. And that's meant that the 60/40 portfolio and stocks and bonds are actually positively correlated with one another. And so the very first thing we're talking to clients about is the extent to which we believe they need to focus on diversification. I think a second factor that we're talking, you know, to clients a lot about is liquidity. Now in the macro sense, we know that one of the reasons that markets have been able to resist some of the pressure is coming from the fed. Raising rates 550 basis points in kind of 15, 16 month period has been because there have been huge offsets in the macro backdrop providing liquidity to the marketplace. So we're talking about the fact that some of those supports to liquidity may, in fact, fall away and go from being tailwinds to being headwinds in 2024. So what does that mean? That means that we need to have perhaps more realistic expectations for overall returns. The third and final thing that we're spending a lot of time with clients on is this idea of what is fair valuation, right? In the last eight weeks of the year, clients were, you know, very I think enamored is probably the right word with the move in the last eight weeks of the year, of course, people had, you know, the fear of missing out. And yet we had to point out that valuations were kind of reaching limits, and we therefore haven't been shocked at this January, the first couple of weeks, markets have maybe stalled out a little bit, having to kind of digest the rate that we've come and the level that we're at. So those are some of the themes that, you know, we've begun to talk about, at least with regard to portfolio construction.

Andrew Sheets: So, Lisa, that's a great framing of it. You know, you mentioned the importance of rates to the equity story, this unusually high correlation that we've had between bonds and stocks. And you have this debate in the market, will the Fed make its first rate cut in March? Will it make its first rate cut in June, like the Morgan Stanley research call is calling for? Is that the same thing? And how important to you in terms of the overall market outlook is this question of when the Fed actually makes its first interest rate cut?

Lisa Shalett: Yeah. For our client base and long term investors, you know, we try to push back pretty aggressively on this idea that any of us can time the market and that there's a big distinction and difference between a march cut and a may or June cut. And so what we've said is, you know, the issue is, again, less about when they actually begin, but why do they begin? And one of the reasons that they may begin later than sooner would be that inflation is lumpy. And I know that some of the economists on our global macro team have that perspective that, you know, the heavy lifting, if you will, or the easy money on the inflation trade has been made. And we were able to get from 9 to 4 on many inflation metrics, but getting from 4 to 2 may require patience as we have to, you know, kind of wait for things like owner occupied rents and housing related costs to come down. We have to wait for the lags in wage growth to come out of some of the calculations, and that may require a pickup in unemployment. We may have to wait for some of the services areas where there has been inflation, things related to automotive insurance and things related to health care for some of those items to settle down as well. And so that might be one of the issues that impacts timing. 

Andrew Sheets: So moving to your second key point around market liquidity. Another factor I want to ask you about, which I think is kind of adjacent to that debate, is what about all this cash? You know, we've heard a lot about record inflows into US money market funds over 2023. You have around $6 trillion sitting in US money market funds. How do you see that story playing out, and how do you think investors should think about that question of should I redeploy my cash, given it's still offering relatively high yields? 

Lisa Shalett: So for our clients, you know, one of the things that we're very focused on, again, because we're taking that much longer time frame is saying, look, how does the current 5.3, 5.25 money market yield compare with expected returns for stocks and bonds over the next couple of years? And in that framing from where we sit, what we're saying is cash is reasonably competitive still. Now if rates come down very, very quickly right, we again get back to that question of why. If rates are coming down very quickly because we have disinflationary growth then, then that might be a signal that it's time to redeploy into riskier assets. Alternatively, if they're cutting because they see deteriorating economic conditions, staying in cash for a little while longer during a slowdown might also be the right thing, even though your yields might be going from five to 4 to 3 and a half. And from where we sit, I think our clients know that our capital market assumptions have erred on the conservative side, no doubt about it. But, you know, we think U.S. equities are apt to return at best in 2024 something in the 4 or 5, 6 range against a backdrop where earnings growth could be 10%. And for, you know, investment grade credit, which I know is your expertise. We're saying, you know, we think that rate risk is moderate from here, that it's asymmetric. 

Andrew Sheets: Lisa, just to bring in your third point on valuations, especially valuations and a potentially higher real rate environment. What should investors do in your opinion to build those diversified portfolios given the valuation reality that they're having to deal with? 

Lisa Shalett: So look, I think our perspective is that in a world where, you know, real interest rates are higher, the dynamics around balance sheet quality really come into the fore dynamics around those business models, where you have to ask yourself, are the companies that I own, are the credits that I own truly able to earn their cost of capital? And you know, those questions tend to put pressure on excess valuations. So when we're building portfolios, at least right now, we have a bias to press up against the current skew in the market, right. We're currently skewed to growth versus value. So we've got a preference for value. We've got some skew towards mega-cap versus large mid or small cap. So we're skewing large mid and small cap and active management versus the cap weighted management. We've had this huge skew towards a US bias in our client portfolios, and we're trying to push back against that and say in a relative value context, other regions like parts of emerging markets, like Japan, like parts of Europe are showing genuine interest. So part of this idea of higher real rates in the US is this idea that other asset classes, other regions than this mega cap U.S. growth bias that has really dominated the themes over the last 18 months, that that might get challenged. 

Andrew Sheets: Lisa, thanks for taking the time to talk. We hope to have you back soon. 

Lisa Shalett: It's always great speaking with you, Andrew. 

Andrew Sheets: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people find the show.